While both were concerned with the destabilising role of endogenous credit money, I remain sceptical about the attempts to link them.

The Austrian business cycle theory is an equilibrium theory whose concern is with (alleged) real distortions in the capital goods sector of the economy caused by the deviation of the bank rate of interest from the imaginary unique Wicksellian natural rate of interest. The theory also requires unrealistic assumptions about the nature of capital. First, it is doubtful whether most capital goods can be usefully categorised into clear higher and lower “orders” at all, and, secondly, heterogeneous capital can also have a significant degree of durability and substitutability. A capital structure in a capitalist economy where we find some important degree of adaptability, versatility and durability in the nature of capital goods means that the “bust” phase of the Austrian business cycle theory is a grossly unrealistic and unconvincing explanation of any real world contraction.

Furthermore, the ABCT is dependent on a tendency to equilibrium by which the bank rate will return to the imaginary natural rate of interest, and thus clear the real capital goods markets. All these things are simply worthless equilibrium theorising, irrelevant to the real world.

But what is even worse is that the ABCT has little concern with financial crises or asset bubbles, the real world economic phenomena associated with credit booms in poorly regulated financial systems.

In contrast, Minsky’s theory takes account of both financial crises and asset bubbles, and is the superior theory without any doubt. Despite some influence from Schumpeter’s equilibrium theories, Minsky’s financial instability hypothesis does not really require general equilibrium assumptions or effects.

Karen I. Vaughn identified the major failing of modern Austrian theory in this respect:

“Mises never discusses the possibility of systematic speculative error except in the context of his trade cycle theory, in which speculators-investors are misled by improper monetary signals emanating from a fractional reserve banking. Yet if the future cannot be predicted, or as Shackle would say, if the future is created out of the actions of the past, why is it not least conceivably possible for speculative activity to be on net incorrect at least some of the time? Certainly, we have the empirical evidence of speculative bubbles that are endogenous to markets as an example of market instability. One would think that the extent and potential limiting factors that affect such endogenous instabilities would be of great importance for fully understanding market orders, yet it is an issue surprisingly missing in the Austrian literature. Hence, although, we can appreciate the force of Mises’ argument as far as it goes, it seems that a crucial part of the case for the effective functioning of a market economy is missing.” (Vaughn. 1994: 87–88).

“From what I understand, Minsky’s position is that credit cycles are self-feeding, as continuing credit expansion is needed to maximize profit. Greater credit expansion implies falling lending standards, in turn increasing the risk of banks’ loan portfolio. From a macro perspective, the greater the credit expansion, the greater the risk of a financial shock. The banking system cannot self-regulate, because there’s no incentive to do so, and therefore the government needs to regulate the industry in a way to achieve an optimal amount of risk.

I don’t find the theory, at least framed in that way, very convincing. First, it’s not clear why growing risk (e.g. a growing probability of loss) doesn’t act as an incentive to restrict a loan portfolio. Second, empirically, there is little evidence that banks disregarded risk.

What? Is there really “little evidence that banks disregarded risk” in the most recent housing market bubble?

I can only conclude that the liar’s loans and NINJA (no income, no job or assets) loans slipped his mind.

As for “growing risk (e.g. a growing probability of loss)” acting as “an incentive to restrict a loan portfolio” one wonders why we have numerous financial crises in history in which banks loaded up on bad assets or pumped out loans to speculators without much interest in restricting their loan portfolios. Australia’s property bubble in the 1880s immediately comes to mind.

BIBLIOGRAPHY
Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition. Cambridge University Press, Cambridge and New York.

Saturday, May 25, 2013

That is, Friedrich von Wieser – the early Austrian economist who succeeded Menger at the University of Vienna from 1903 and who was the teacher of Friedrich August von Hayek – according to Jörg Guido Hülsmann:

“It is not surprising that Böhm-Bawerk and Mises came to radically different policy conclusions from Wieser and Schumpeter [sc. about the role of money]. Whereas Mises held that the stock of money was ultimately irrelevant, Wieser stressed that money’s function as a measuring rod must not be interfered with. Its value should be as stable as possible, and all destabilizing influences should be eliminated. Wieser suggested that one could optimize the national currency by abolishing commodity money and putting a pure paper money in its place. In fact, paper would be more stable because its value is not subject to the influence of the non-monetary demand for the monetary commodity.” (Hülsmann 2007: 235–236).

How times have changed.

But this confirms that there was a forgotten wing of the early Austrian school, whose views were different from modern Austrians, and Wieser was an important member of that wing.

Wednesday, May 22, 2013

Kirzner (1985) is a discussion of Kirzner’s interpretation of the role of prices in market economies, but heavily based on Hayek’s work.

In the first section, I sketch Kirzner’s argument. In the second I provide a critique.

I. Kirzner on Hayek on Prices
Hayek’s view of the role of prices as communicating economic knowledge is well known.

In a market for any particular commodity, an equilibrium market price equates demand with supply and ensures that there is no excess demand or excess supply (Kirzner 1985: 197). Equilibrium market prices communicate the necessary information to buyers and sellers to achieve economic coordination (Kirzner 1985: 198). In this economic sense, an equilibrium (or market clearing) price is the “right” price. In a general equilibrium, there is perfect communication signalling and economic coordination.

But prices in the real world are virtually always disequilibrium prices, and the general system can never be in a general equilibrium state. Kirzner – like Hayek – conceives the price system as providing a mechanism to progressively improve information and coordination in relation to the past. Disequilibrium prices may communicate incorrect information and result in waste, but their movement towards equilibrium values permits a “discovery” process by market participants to generate greater economic coordination (Kirzner 1985: 205).

That is, in an uncoordinated or relatively uncoordinated economy, a flexible price system in which market buyers and sellers move prices in trades towards their market-clearing values will

“generate systemic changes in market decisions about price offers and bids, in a way that, by responding to the regrettable results of initially uncoordinated sets of decisions, tends to replace them by less uncoordinated sets” (Kirzner 1985: 198).

Thus even when prices are in disequilibrium they will achieve this higher degree of coordination as long as in exchanges they are flexible and moved towards their equilibrium (or market clearing) value.

For example, excess supply in a particular market indicates that prices are too high, so that sellers will eventually move their price downwards (Kirzner 1985: 199).

Disequilibrium prices in the sense of prices not at costs of production also provide profit and loss (Kirzner 1985: 205), and higher profits signal that entrepreneurs should move into these markets, while losses signal that they should move out into other lines of production.

Kirzner contends that Hayek sometimes failed to communicate properly this point about the coordinating role of flexible disequilibrium prices in his earlier work (Kirzner 1985: 203), but that it is brought out most clearly in Hayek’s papers “Competition as a Discovery Procedure” (Hayek 1978) and “The Meaning of Competition” (Hayek 1948).

II. Critique
But what are the problems with this Austrian model of economic coordination? Kirzner complains that “governmentally imposed obstacles to price flexibility” thwart the process of economic coordination (Kirzner 1985: 203).

But with widespread fixprice markets where administered prices dominate, the private sector itself already overwhelmingly shuns the flexible price system required in the ideal and almost utopian vision of Austrian economics. Disequilibrium prices are deliberately created and maintained by fixprice enterprises in a vast swathe of the economy, simply because they prefer it that way. Such businesses are not generally in the habit of using flexible prices as their normal method of clearing supply, or equating demand with supply. In other words, the whole Austrian view that flexible movement of prices towards market-clearing levels provides continuing, coordinating adjustment of supply and demand and permits a “discovery” process for capitalists is simply wrong in the fixprice markets. And these fixprice markets dominate advanced capitalist economies.

Even the existence of “clearance” and “liquidation” sales do not change this fact, for clearance sales are very much the exception, not the rule. In the retail trade, for example, what are called “clearance sales” are often a matter of some discounts, but with deceptive psychological tricks with advertising. Very often producers with excess supply will merely add this to inventory.

Supply is mostly equated with demand by direct output and employment changes, and changes in the quantity of stock. This is how a real economy generally achieves economy coordination. Prices are relatively inflexible, and so much so that fixprice firms only rarely change their prices, perhaps on average once a year (Melmiès 2010: 450), and even then the price adjustments are mostly caused by changes in the costs of factor inputs and wages.

Another consequence of these fixprice markets is that profits too tend to be relatively stable. A business wants its profit markup to be relatively stable (at least in terms of avoiding large falls in it), and so there is some degree of stability of profits that results from price administration (Gu and Lee 2012: 461). Stable profits in turn allow stable margins for internal financing of investment (Melmiès 2012).

Stable fixprices mean a rise in money supply or credit does not necessarily or even generally cause the price “distortions” imagined in Austrian theory, for fixprices are generally inflexible with respect to demand changes (though matters are different in flexprice markets).

There is no doubt that profit and loss has a major role to play in market economies in driving investment, but the particular importance given to profit and loss signals in the Austrian view of flexible prices is exaggerated, for fixprice firms generally shun the losses that they would suffer by sharply reducing the prices of their goods below costs of production to clear their product markets (Gu and Lee 2012: 461).

As noted above, fixprices are generally not adjusted in response to changes in demand, and instead output or inventory will be adjusted. Therefore when demand has changed in response to changes in credit, it does not follow that, say, consumer prices will rise and then the profits in those consumer industries as well, which will (according to Austrian theory) drive overinvestment in these lines of production. Instead, direct output and employment changes are more likely. Profits will increase but not because prices have increased: it is because extra demand has led to extra sales with increased production. When demand falls, changes in inventory and production will follow.

Another assumption underlying the Austrian vision of economics is the belief in a strong tendency for profits to be equalized across the economy. But that idea is unconvincing. It assumes an unrealistic degree of competition across markets, whereas in the real world very different degrees of competition between industries, market power, barriers to new entry, patents, labour issues and other factors will thwart the process.

One suggestion is that post-1945 macroeconomic stabilisation has prevented the “strong Fisherian debt deflation mechanism” that was seen in pre-1945 business cycles (Schularick and Taylor 2012: 1032).

Broadly, this seems to support Minsky’s and Kindleberger’s view of financial crises as induced by credit booms where intense speculation on asset prices has occurred (Schularick and Taylor 2012: 1032).

The lesson is that the direction of credit and financial regulation are very important.

It is strange that there is no mention of the need to maintain aggregate demand, but otherwise the speculations at the end make interesting reading.

I am inclined to think we are only seeing the the small effects of these processes now, and the really huge changes will be more a medium to long term problem, something that will become acute from 2030s or 2040s, though that is just a wild guess.

Lavoie makes an important and perhaps not well understood point about money under certain gold standard regimes:

“What about [sc. endogenous money in] fixed exchange regimes (gold standard regime or dollar standard regime)? Mainstream economists argue that monetary policy is then impossible. Balance of payments deficits (surpluses) lead to foreign reserve losses (gains), and hence either lead or should lead to reductions (increases) in the monetary base and in the money supply, followed by endogenous hikes (cut-backs) in interest rates. In such a context, the money supply is endogenous, but it is supply-led, no longer demand-led. It is thus totally at odds with the post-Keynesian approach. It is also at odds with empirical facts.

Studies devoted to both gold standard periods have shown that the rules of the game did not apply whatsoever (Lavoie, 2001b). Increases or decreases in central bank foreign assets were compensated by fluctuations of central bank domestic assets in the opposite direction. This is the ‘compensation’ thesis, advocated in particular by French central bankers and Le Bourva (1992, pp. 462–3). Compensation is the rule rather than the exception. In standard terminology, fluctuations in foreign reserves were ‘sterilized’ or ‘neutralized’. Neutralization arose either automatically, at the initiative of the private sector, or naturally, as a result of the normal behaviour of the central bank to sustain the payment system. Thus, even in the gold standard period, fixed exchange rates did not prevent central banks from setting interest rates, while money creation was still demand-led.” (Lavoie 2006: 29).

But even with these activist measures by certain central banks in the gold standard era, did the endogenous broad monetary systems meet the demand for credit?

The deflationary period from 1876 to 1896 that most countries experienced in the 19th century suggests that it did not (even though part of the explanation for the deflation appears to be price declines in many commodities as production in the Americas and Australia expanded).

More interesting are the implications of large-scale industrial use of 3-D printing, or more likely a future form of it.

Current 3-D printing is an early form of nanotechnology. Back in the 1990s, “nanotechnology” was a buzzword that one kept hearing in speculations on future technology, and probably a lot people became skeptical that a “nanotech revolution” or anything like it was anything but a pipe dream, and only something realisable in the distant future.

But now one gets the sense that things are moving much faster than many people thought. 3-D printing and the ongoing technological advances in automation and robotics suggest that the world may experience a new or “Third Industrial Revolution” in the medium and long term future. I say the “medium and long term future”, because we are only just seeing the early signs of it now, and no doubt the progeny of these current technologies will make current 3-D printing look pretty primitive.

Moreover, these developments are another reason why re-shoring and the return of manufacturing to Western nations might happen (although as Vernengo points, the US still has a pretty impressive industrial sector). Of course, I do not think it will necessarily happen if left to market forces. What is called for is a kind of activist industrial policy and, above all, demand management and full employment policies to both accelerate it and take advantage of the growth opportunities opened up by new technologies.

We may see strong deflationary forces in the 21st century, in the sense that there will be steep price declines in the costs of manufacturing, certainly once human labour is reduced, productivity growth soars, and a few decades of innovation and price declines occur in these new capital goods themselves using all the technologies above.

Most probably, the great deflation of the late 19th century from 1873 to 1896 had just as much to do with productivity growth from new technologies and the opening up of production in the Americas and Australia as it did with poor money supply growth rates caused by a relatively inelastic monetary base in many nations.

But with fiat money and fully endogenous money supplies now we may avoid harmful deflation that induces debt deflationary forces, which were very probably a major economic problem from 1873 to 1896.

Here is an interesting anecdote from Rothbard on British economists who were influenced by George L. S. Shackle whom Rothbard called the “English Subjectivist School”:

“An amusing but instructive event occurred on the occasion of the conference of American Austrians at Windsor Castle in the summer of 1976. Under the good offices of Professor Stephen C. Littlechild of the University of Birmingham, a kind of summit conference was arranged so that some of the American Misesians could meet the English Subjectivist School, as the Shackleians call themselves. The eminent Subjectivists at the meeting included the doyen of that school, Shackle himself, as well as Terence W. Hutchison, Jack Wiseman, and Brian Loasby. At one point, the Subjectivists were lamenting that they could not offer a program of graduate economics courses as alternatives to the neoclassical paradigm, since all they had produced were a few critical essays but no substantial body of economic theory. I replied in some surprise that there was indeed a great deal of systematic Austrian literature available, including works by Mises, the early Hayek, and my own work, in addition to volumes of Böhm-Bawerk and Frank A. Fetter, among others. The blank looks of incomprehension on the faces of the distinguished Subjectivists were a revelation of the enormous extent of the inherent gulf between Shackleian Subjectivists and Misesians.” (Rothbard 2011: 176–177, n. 21).

So who were these English Subjectivists? Economists in the tradition of Shackle?

Rothbard’s “English Subjectivists” are a peculiar group of economists, apparently influenced by Shackle who was linked to Post Keynesianism, but affiliated with the Austrian school. Excepting Shackle, perhaps they are better called “British Austrians.”

Moreover, Rothbard’s idea that they were unfamiliar with the writings of the Austrian school (especially Hayek) is nonsensical.

My final point concerns George L. S. Shackle and Lachmann. Lachmann at one point called Shackle an “Austrian” (Lachmann 1978: 15), even though Shackle was a Keynesian in his policy prescriptions. Some classify Shackle as a hybrid Austrian/Post Keynesian (or someone who drew “Keynesian conclusions from Austrian premises”). But an equally valid question might be: how should Lachmann be classified? I have to admit that Lachmann intrigues me. He is the most interesting Austrian. He was willing to endorse Keynesian stimulus in a depression. Is it possible that some radical subjectivists like Lachmann could be regarded as almost “Keynesian” Austrians?

Thursday, May 16, 2013

“It is hardly necessary to say that Post Keynesians reject the ‘old classical’, ‘Bastard Keynesian’ and ‘New Keynesian’ argument that unemployment is due to the existence of a real wage above the equilibrium or ‘market clearing’ level owing to the trade union or government interference in the operation of the free market for labour. They also dismiss the ‘New Classical’ notion that unemployment is the (voluntary) result of intertemporal income-leisure choices by individual workers. As was demonstrated above, neither claim is supported by micro foundations; and neither has any macro foundation whatsoever. A Post Keynesian theory of unemployment would instead start from the proposition that in aggregate the level of employment depends on the level of output, which is itself determined by aggregate demand and therefore heavily influenced by macroeconomic policy. Unemployment is simply the difference between the level of employment and the aggregate supply of labour, which may – as explained earlier – safely be regarded as invariant in the short run with respect to the real wage, but variable with respect to the number of job opportunities.” (King 2002: 84).

In short, it is, above all, aggregate demand that drives output and the level of employment. The existence of vast and important fixprice markets in any modern capitalist economy means extra demand generally increases output and employment. The inducement to invest is obviously an important factor.

The level of employment of labour is more than just a simple function of labour supply and demand curves, as in neoclassical theory, where demand is the marginal revenue product of the labour factor (Lavoie 1992: 219) and zero unemployment means a clearing of the labour market (Davidson 2011: 202).

In fact, the demand for and supply of labour are not “well behaved” in a neoclassical sense (Lavoie 1992: 217). In aggregate terms, “one should not expect to find a continuous negative relationship between the demand for labour and the aggregate real wage” (Lavoie 1992: 217). Although excessive wage growth does induce inflation, wages in real world market economies do not need to be, and normally are not, market-clearing wages, and economies can have high employment, strong real output growth and productivity growth without them.

Another fundamental insight is that work does not necessarily have to “carry disutility” (Lavoie 1992: 218). Work can be rewarding, enjoyable and satisfying to some people in certain occupations (Lavoie 1992: 218).

Wednesday, May 15, 2013

Walrasian general equilibrium theory is the greatest obstacle to the development of economics as a science.

That is the bold contention of Nicholas Kaldor in his article “The Irrelevance of Equilibrium Economics” (Economic Journal 82 [1972]: 1237–1252), and it is undoubtedly true.

One can summarise Kaldor’s argument as follows:

(1) General equilibrium (GE) theory was invented by Walras, but found one of its major 20th century developers in the French economist Gerard Debreu.

At the time Kaldor was writing, Debreu’s Theory of Value: An Axiomatic Analysis of Economic Equilibrium (1959) was a notable exposition of the mathematised Walrasian general equilibrium theory.

Kaldor notes how the book does not purport to be an empirical description of reality, as, for instance, in describing how prices are actually formed in the real world (Kaldor 1972: 1237).

GE theory is an example of the aprioristic or deductive method in economics: a formal system in which a set of theorems are logically deduced from certain assumptions (Kaldor 1972: 1237). But there is no real attempt to verify whether the assumptions are true, or whether its system of established equilibrium prices has any explanatory power or even relevance to actual market economies (Kaldor 1972: 1238).

Another delusional assumption is that real economies can approach, or are close to, a state of equilibrium (Kaldor 1972: 1239).

Kaldor rightly rejects all these neoclassical assumptions as untrue, and concludes that the main theorems of neoclassical theory “cannot possibly hold in reality” (Kaldor 1972: 1240).

(2) Kaldor argued that where modern economics went wrong – both in Classical political economy and neoclassical economics – was a fixation with the theory of value, or a deeply mistaken theory of prices, in which the question of how value and price are determined for factor inputs and products takes central stage (Kaldor 1972: 1241). The major flaw in this enterprise has been the assumption of constant returns to scale (Kaldor 1972: 1241).

But modern capitalism based on technology, innovation and mass production has increasing returns to scale as its fundamental trait in many industries (above all, manufacturing) (Kaldor 1972: 1242). Division of labour is not only applicable to working human beings, but also to labour-saving machinery and technology. When mass production occurs in industry and output is large, it pays to invest in or implement labour-saving machinery. The capital–labour ratio in production is therefore more a function of market scale than the prices of relative factor inputs (e.g., the price of labour versus machinery) (Kaldor 1972: 1242).

Kaldor sees these insights as revolutionary in their ability to overthrow neoclassical theory: once we assume that the production of most commodities is subject to increasing returns to scale, the whole notion of general equilibrium theory itself must be thrown side (Kaldor 1972: 1244). Why? Because a major assumption of neoclassical theory is that a convergence to an equilibrium state is governed by exogenous forces such as unchanging production patterns over time (Kaldor 1972: 1244).

But once increasing returns to scale are assumed, the dynamic system has endogenous forces that drive it in ways away from equilibrium.

(3) Kaldor moves on to another issue by the end of his paper, which is the nature of buffer stocks in modern economies.

In primary product markets, which tend to be a rough equivalent of competitive flexprice markets, stocks are carried by merchants who are independent of producers and consumers. These dealers carry stocks that act as buffers.

But in other markets where increasing returns to scale exist often producers carry their own stocks and adjust their output in response to demand (Kaldor 1972: 1250).

The ability to increase production in response to demand is achieved in modern capitalism by an endogenous money supply: a banking and monetary system where capital investment can be financed by new money.

Kaldor notes that

“This is the real significance of the invention of paper money and of credit creation through the banking system. It provided the pre-condition of self-sustained growth. With a purely metallic currency, where the supply of money is given irrespective of the demand for credit, the ability of the system to expand in response to profit opportunities is far more narrowly confined.” (Kaldor 1972: 1250).

BIBLIOGRAPHY
Debreu, Gerard. 1959. Theory of Value: An Axiomatic Analysis of Economic Equilibrium. Wiley, New York and London.

Monday, May 13, 2013

Sir John Hicks’s book Capital and Growth (Oxford, 1965) has an important discussion of the history of fixprices.

The significance of that discussion is described by the Austrian Ludwig Lachmann in a review of article of Capital and Growth:

“Two other matters of great significance are dealt with in the first part of the book. As others have done before him, Professor Hicks finds it necessary to stress, in his chapter on Marshall’s method, that our world differs from that which Marshall took for granted in that we live in a world of prices ‘administered’ by manufacturers, ‘but in those days even manufactured goods usually passed along a chain of wholesalers and retailers, each of whom was likely to have some independent price-making opportunity.’ (55) Again, like others before him, our author attributes the cause of this change to the virtual disappearance of the wholesale merchant and his price-setting function after 1900. Formerly ‘the initiative would come from the wholesaler or shopkeeper, who would offer higher prices in order to get the goods which, even at the higher price, he could re-sell at a profit. Similarly, when demand fell, it would be the wholesaler who would offer a lower price. The manufacturer would have to accept that price if he could get no better.’ (56) Hence, while Marshall’s was a world of flexible prices, even though not of ‘perfect competition,’ ours is a ‘fixprice world’ with prices set on a ‘cost plus’ basis and wage rates as ultimate price determinants.

The analytical significance of this historical change lies, on the one hand, in the fact that the ‘Temporary Equilibrium Method’ which Hicks himself, following Lindahl, used in Value and Capital in 1939, has lost much of its validity. ‘The fundamental weakness of the Temporary Equilibrium method is the assumption, which it is obliged to make, that the market is in equilibrium—actual demand equals desired demand, actual supply equals desired supply—even in the very short period.’ (76) Hence we have to look for another method of dynamic analysis. To find it we must move nearer to Keynes and his successors who are here given credit for having understood, earlier than others, that a fixprice world requires a fixprice method of analysis.” (Lachmann 1977: 238–239).

Lachmann was well aware of the significance of fixprices, and discussed them in The Market as an Economic Process (Oxford, 1986), pp. 122–136.

Lachmann stated:

“Those who glibly speak of ‘market clearing prices’ tend to forget that over wide areas of modern markets it is not with this purpose in mind that prices are set. They seem unaware of the important insights into the process of price formation, an Austrian responsibility, of which they deprive themselves by clinging to a level of abstraction so high that on it most of what matters in the real world vanishes from sight.” (Lachmann 1986: 134).

Lachmann even concluded that his own fellow Austrians had badly neglected the task of studying real world price formation (Lachmann 1986: 130–131).

That is a failing that most Austrians are guilty of to his day, despite some discussion of the issue in Reisman (1996), pp. 414–417, where Reisman does not consider the implications of cost of production plus profit mark-up pricing for Austrian theories of economic coordination.

A nice video here of Professor Bill Mitchell (an Australian Modern Monetary Theory economist) of Billyblog discussing the arguments for full employment focusing on the issue of discrimination, part of a University of Western Sydney Open Forum, held on January 16, 2012.

Saturday, May 11, 2013

Mises’s notion of economic calculation and coordination in market economies is at the heart of Austrian economics.

I provide an overview below and critique.

Note that I am not discussing the issues of the strict socialist calculation debate, which should be differentiated from Mises’s views on economic calculation in capitalist systems where there are money and money prices for capital goods (unlike the socialist economies Mises imagined).

In market societies, there are money prices, and economic calculation “is calculation in terms of money prices” (Mises 1998: 206). Money prices allow us to compare “input and output on a common basis” (Mises 1998: 209), and money is the “common denominator of economic calculation” (Mises 1998: 215). Economic calculation “in terms of money prices is the calculation of entrepreneurs producing for the consumers of a market society” (Mises 1998: 217), and it deals with the future, though it takes “pasts events and exchange ratios of the past into consideration” (Mises 1998: 211).

The aim that economic calculation achieves is to “establish the outcome of acting by contrasting input with output” (Mises 1998: 211). The prices of the past are starting points in the endeavour to “anticipate future prices” (Mises 1998: 213). Money prices allow the calculation of profit and loss (Mises 1998: 231).

So far so good.

Mises states the monetary factors needed for a reasonable level of economic calculation in a market system:

“The first aim of monetary policy must be to prevent governments from embarking upon inflation and from creating conditions which encourage credit expansion on the part of banks. But this program is very different from the confused and self-contradictory program of stabilizing purchasing power.

For the sake of economic calculation all that is needed is to avoid great and abrupt fluctuations in the supply of money. Gold and, up to the middle of the nineteenth century, silver served very well all the purposes of economic calculation. Changes in the relation between the supply of and the demand for the precious metals and the resulting alterations in purchasing power went on so slowly that the entrepreneur’s economic calculation could disregard them without going too far afield. Precision is unattainable in economic calculation quite apart from the shortcomings emanating from not paying due consideration to monetary changes. The planning businessman cannot help employing data concerning the unknown future; he deals with future prices and future costs of production. Accounting and bookkeeping in their endeavors to establish the result of past action are in the same position as far as they rely upon the estimation of fixed equipment, inventories, and receivables. In spite of all these uncertainties economic calculation can achieve its tasks. For these uncertainties do not stem from deficiencies of the system of calculation. They are inherent in the essence of acting that always deals with the uncertain future.” (Mises 1998: 225).

So according to Mises what is required is as follows:

(1) for the sake of “economic calculation all that is needed is to avoid great and abrupt fluctuations in the supply of money”; and

(2) slow changes in purchasing power of money (as in the 19th century and gold standard eras), so that the “entrepreneur’s economic calculation could disregard them without going too far afield.”

This entails that mild changes in money’s purchasing power – whether inflation or deflation – are, according to Mises, consistent with effective economic calculation. For example, the 19th century had bouts of inflation, such as from 1896–1914, yet presumably Mises thought that economic calculation proceeded during this period without being seriously impaired.

But there is also a clear contradiction here: Mises says that governments have to be prevented “from creating conditions which encourage credit expansion on the part of banks.” Yet the 19th century and gold standard era had significant credit expansion, as I have demonstrated here.

Yet presumably Mises held that the 19th century did have reasonably effective economic calculation. Either Mises must

(1) abandon the idea that 19th century had reasonably effective economic calculation, or

(2) admit that some moderate degree of credit expansion is consistent with economic calculation.

If the latter, then it follows that the post-1945 era with its relatively low inflation and moderate credit expansion must also have had reasonably effective economic calculation.

But how does the price system perform its most fundamental task in economic calculation and coordination? Why, for example, would Austrians complain about excessive money supply expansion “distorting” prices and frustrating or impairing economic calculation?

The reason is that the Austrians see prices revolving around or moving towards their market-clearing values. The market-clearing price is the “right” price in an economic sense, because it is the adjustment of prices by market participants in their trades towards their market-clearing levels that coordinates, or equates, supply and demand.

In particular, the capitalists who produce consumer goods have a crucial role here:

“The driving force of the market process is provided neither by the consumers nor by the owners of the means of production – land, capital goods, and labor – but by the promoting and speculating entrepreneurs. These are people intent upon profiting by taking advantage of differences in prices. Quicker of apprehension and farther-sighted than other men, they look around for sources of profit. They buy where and when they deem prices too low, and they sell where and when they deem prices too high. They approach the owners of the factors of production, and their competition sends the prices of these factors up to the limit corresponding to their anticipation of the future prices of the products. They approach the consumers, and their competition forces prices of consumers’ goods down to the point at which the whole supply can be sold. Profit-seeking speculation is the driving force of the market as it is the driving force of production.” (Mises 1998: 325–326).

“Mises conceives the market process as coordinative, ‘the essence of coordination of all elements of supply and demand.’ This means that the structure of realized (disequilibrium) prices, which continually emerges in the course of the market process and whose elements are employed for monetary calculation, performs the indispensable function of clearing all markets and, in the process, coordinating the productive employments and combinations of all resources with one another and with the anticipated preferences of consumers.” (Salerno 1993: 124).

“prices that are generated by the market process and serve as the data for economic calculation. These are realized prices; or, in other words, they are the actual outcome of the historical market process at each moment in time and are determined by the value scales of the marginal pairs in each market. They are, therefore, also market-clearing prices the establishment of which coincides with a momentary situation, what Mises calls the ‘plain state of rest’ (PSR), in which no market participant, given his existing marginal-utility rankings of goods and money and knowledge of prevailing prices, can enhance his welfare by participating in further exchange. However, despite their character as market-clearing prices, these are also disequilibrium prices. Thus as a consequence of the unavoidable errors of entrepreneurial forecasting and price appraisement under uncertainty, most goods are sold at prices that do not conform to their monetary costs of production, thereby generating realized profits and losses for producers.” (Salerno 1990: 121).

“Despite the economy’s disequilibrium character, however, the market-clearing process has an important function to perform in the pricing and allocation of scarce resources, a function that Hutt felicitously described as ‘the dynamic coordinative consequences of price adjustment.’ According to Mises, the coordinative social appraisement process of the market insures that the current price of every scarce resource is equal to its expected marginal revenue product (discounted by the interest rate), and thus that all existing productive resources are always fully employed in those uses that entrepreneurs consider to be most valuable in light of their knowledge of the technological possibilities and their forecasts of future market conditions, including their appraisements of prospective output prices.

As I have argued elsewhere, a Misesian conceives the market’s coordinative process as extremely hardy and no more liable to be disrupted by market-produced changes in the money-spending stream, such as hoarding, dishoarding, and changes in the production costs of mining gold, than by changes in the ‘real’ data of the economic system. As Mises argued, however, the process can be hampered and distorted by external intervention that undermines or nullifies its market-clearing property in resource markets, a property that may be crudely and temporarily restored by an episode of unanticipated inflation which lowers the real prices of labor and other resources toward equilibrium levels. Thus Mises’s analysis explains the observed effect of inflation on employment and output in a way that is fully consistent with the microfoundations of Austrian monetary theory and does not invoke ad hoc and unrealistic assumptions about the behavior of market participants.” (Salerno 2010: 210–211).

The crucial point is that it is flexible prices that are supposed to coordinate demand with supply, as noted by Rothbard:

“There is no reason why prices cannot fall low enough, in a free market, to clear the market and sell all the goods available. If businessmen choose to keep prices up, they are simply speculating on an imminent rise in market prices; they are, in short, voluntarily investing in inventory. If they wish to sell their ‘surplus’ stock, they need only cut their prices low enough to sell all of their product. But won’t they then suffer losses? Of course, but now the discussion has shifted to a different plane. We find no overproduction, we find now that the selling prices of products are below their cost of production. But since costs are determined by expected future selling prices, this means that costs were previously bid too high by entrepreneurs. The problem, then, is not one of ‘aggregate demand’ or ‘overproduction,’ but one of cost-price differentials. Why did entrepreneurs make the mistake of bidding costs higher than the selling prices turned out to warrant? The Austrian theory explains this cluster of error and the excessive bidding up of costs; the ‘overproduction’ theory does not. In fact, there was overproduction of specific, not general, goods. The malinvestment caused by credit expansion diverted production into lines that turned out to be unprofitable (i.e., where selling prices were lower than costs) and away from lines where it would have been profitable. So there was overproduction of specific goods relative to consumer desires, and underproduction of other specific goods.” (Rothbard 2008: 56-57; emphasis in original text).

So in the Austrian theory businesses must lower prices to clear their product market, even if the price falls below the cost of production. If they suffer losses, this is only because they overproduced goods in specific industries, and they must make supply adjustments in those specific industries only, to allow prices to be adjusted upwards to restore profits.

Finally, the role of flexible wages is also described by Salerno:

“Now, unlike the Chicago price theorists, Mises and the Misesian wing of the modern Austrian school, do not believe that the market economy is ever at or even within sight of long-run general equilibrium. Rather, the structure of realized market-clearing prices is seen by Austrians as functioning, despite its non-general equilibrium character, to continuously coordinate the uses and technical combinations of available resources in light of entrepreneurial forecasts of constantly shifting future market conditions, including consumer preferences. Hence, for Mises, in direct contrast to Friedman, it is the decline in real wage rates toward their market-clearing levels brought about by unforeseen inflation that is equilibrating – albeit crudely and temporarily; the ensuing restoration of the former level of real wage rates by renewed union restrictionism, on the other hand, marks a reversion to a pervasive and chronic disequilibrium situation in which the labor market is precluded from establishing even a coordinative, momentary equilibrium of supply and demand, while the market’s long-run tendency to generate a structure of final equilibrium wage rates and optimal allocation of labor is permanently stifled.” (Salerno 2010: 210–211).

So what is wrong with this fundamental Austrian theory? Why is it flawed?

It is wrong for the following reasons:

(1) we have already seen above that Mises’s views on whether economic calculation can still occur properly when there is a credit expansion on the part of banks is confused and inconsistent.

Mises’s assertions on the 19th century entail either (a) that a modern market economy even with moderate money supply and credit expansion and low inflation can presumably have effective economic calculation, or (b) that Mises must abandon the idea that 19th century had reasonably effective economic calculation.

The consequences of (b) entail that modern capitalism has never had any effective economic calculation! If any Austrians want to take this option, then they must explain how real output has expanded at all over the past 200 years and how stunning growth in real output and investment as in, for example, 1945 to 1973 were able to occur.

I take it that few sensible Austrians will opt for (b), and (a) will be their chosen response. But option (a) entails that modern market economies, even with mild to moderate credit expansion, can still achieve economic calculation.

(2) the role of the price system in Mises’s vision of economic calculation is deeply flawed. Mises sees the price system as having flexible prices that move towards their market-clearing values: this is how supply and demand are equated.

But that is most certainly not the reality in vast swathes of modern market economies where fixprices and administered prices are the norm. Many prices in consumer goods, capital goods, retail trade, and service industries are administered prices. They are not adjusted towards their market-clearing values by businesses.

Administered prices are generally not changed in response to demand, and so most of the private sector itself does not behave in the way posited and required by Austrian theory. Money supply growth and credit expansion do not generally “distort” fixprices away from their market-clearing values, because fixprices are not even set to attain those market-clearing values at all.

Yet supply and demand are coordinated in modern capitalist economies, but by businesses making direct adjustments in their output and employment in response to demand.

It is direct changes to supply that equate supply and demand, not flexible prices.

(3) the whole notion that there exists a universal set of market-clearing values for prices and wages just waiting to be discovered by adjusting prices or Walrasian tâtonnement is itself little more than a quasi-theological superstition of modern neoclassical and Austrian economics, because no economist can prove that the law of demand is universally true.

It is not just that the law of demand, with its ceteris paribus (or “[all] other things being equal”) assumption, is defined at a level of abstraction so high that in practice it is unrealistic, but that even in an abstract sense it cannot be proven. Steve Keen demonstrates that the law of demand can be proven only in the case of a single consumer (Keen 2011: 51).

Nor can we generalise the law of demand and prove that it necessarily applies to a whole market either (Keen 2011: 51). A market demand curve “can take any shape at all – except one that doubles back on itself” (Keen 2011: 52).

Note that even if you do not accept this radical critique of the law of demand, factor (2) above – the existence of fixprice markets – is sufficient to refute the Austrian theory of economic coordination.

(4) the employment of labour by business is a much more complicated process than just the demand for labour as predicted by labour supply and demand curves.

Expectations of businesses are subjective, and liable to cycles of pessimism and optimism. Lowering the interest rate or lowering the real wage does not induce the necessary investment when business expectations are shattered or weak. So many businesses depend on demand, sales orders or sale volume (or what can be called “quantity signals”) as the factors that induce them to employ labour.

This means that it is aggregate demand that is the major factor in inducing additional employment in modern economies, not necessarily wage cuts.

All in all, there is not much left of the Austrian vision of economic calculation: it is based on a deeply unrealistic theory of prices, does not consider the reality of fixprices, and fails to even accurately understand how supply and demand are equated in the real world.

The real world, with its extensive fixprices and direct output adjustments, is better modelled and understood by Keynesian economics.

Thursday, May 9, 2013

“A good case can be made out for short-term government debts under special conditions. Of course, the popular justification of war loans is nonsensical. All the materials needed for the conduct of a war must be provided by restriction of civilian consumption, by using up a part of the capital available and by working harder. The whole burden of warring falls upon the living generation. The coming generations are only affected to the extent to which, on account of the war expenditure, they will inherit less from those now living than they would have if no war had been fought. Financing a war through loans does not shift the burden to the sons and grandsons. It is merely a method of distributing the burden among the citizens. If the whole expenditure had to be provided by taxes, only those who have liquid funds could be approached. The rest of the people would not contribute adequately. Short-term loans can be instrumental in removing such inequalities, as they allow for a fair assessment on the owners of fixed capital.” (Mises 1998: 213).

Come again? According to Mises, there is a good case for short-term government debt under special conditions. Presumably, war in legitimate self defence is one of them.

And “financing a war through loans does not shift the burden to the sons and grandsons.” That is to say, the real burden of required real resources for the war “falls upon the living generation” and is “a method of distributing the burden among the citizens.”

Funny, but Abba Lerner said something like this.

But many modern Austrians would say the exact opposite: they argue that government debt for public infrastructure and public works spending now (as in a Keynesian stimulus) impoverishes future generations. Those modern Austrians should have read their Mises more closely!

And a Keynesian would reply that the real burden is only felt by the present generation, because all real resources can only be provided now.

Mises says:

“The coming generations are only affected to the extent to which, on account of the war expenditure, they will inherit less from those now living than they would have if no war had been fought.”

This is reasonable in that the future generations will lose both capital goods and (probably mostly durable) consumption goods that could have been produced in place of war materiel.

But the other side of the coin is that allowing an economy to collapse into depression without quick stimulus also impoverishes future generations in exactly the same way: the future generations lose the capital goods and durable consumption goods that could have been produced had stimulus been applied.

The future repayment of money debt is a mere redistribution of income at a future period. There is no way for the future generations to send real resources back in time for us to use now.

Wednesday, May 8, 2013

Two standard works on Post Keynesian price theory are Downward (1999) and Lee (1998).

But administered pricing has been recognised and studied by economists since the 1930s, and the literature is vast. Below is a sample of the important early literature on fixprices and administered pricing:

Gardiner C. Means studied price setting by modern corporations in the United States, and was one of earliest and most important economists who examined administered pricing. He concluded, after extensive empirical research, that prices of goods produced in many corporations are set by a mark-up on cost of production (Downward 1999: 50).

He was clear that the neoclassical price theory with its ideas of flexible prices adjusted by agents in auction or auction-like transactions is not a description of reality for most markets:

“Basically, the administered-price thesis holds that a large body of industrial prices do not behave in the fashion that classical theory would lead one to expect. It was first developed in 1934–35 to apply to the cyclical behavior of industrial prices. It specifically held that in business recessions administered prices showed a tendency not to fall as much as market prices while the recession fall in demand worked itself out primarily through a fall in sales, production, and employment.” (Means 1972: 292).

“Fourth, the actual behavior of administration-dominated prices … tends to differ so sharply from the behaviour to be expected from classical theory as to challenge the basic conclusions of that theory. However well the theory may apply to market-dominated prices, it would not seem to apply to the bulk of the administration-dominated prices in the sample or to that part of the industrial world which they typify.

Until economic theory can explain and take into account the implications of this nonclassical behavior of administered prices, it provides a poor basis for public policy. The challenge which administered prices make to classical economics is as fundamental as that made by the quantum to classical physics.” (Means 1972: 304).

Hall and Hitch were part of the Oxford Economists Research Group and postulated a “full cost” theory of pricing, plus mark-up for profit (Downward 1999: 46). Mark-ups are constrained to some extent by competing businesses.

Kalecki, M. 1971. Selected Essays on the Dynamics of the Capitalist Economy. Cambridge University Press, Cambridge.

Michał Kalecki (1939) treats fixprices as set by means of production costs and profit. He also noted the important role of excess capacity in industries. Hall and Hitch’s work influenced Kalecki’s views on prices (Downward 1999: 51).

In Kalecki (1954 and 1971), he developed his theory of prices. He divided prices in market economies into two types, as follows:

(1) cost determined prices; and

(2) demand determined prices.

Most finished goods are cost determined, while many raw materials and primary commodities are demand determined (that is, flexprice markets).

Most manufactured goods have prices that are cost determined. Prices are set under conditions of uncertainty and, crucially, profits are not, strictly speaking, maximised in the neoclassical sense (Downward 1999: 52).

Normal price floors are set by costs of production, and ceilings – at least to some extent – by the average price level in the particular industry concerned.

Andrews noted the existence of excess capacity in many firms and how administered pricing is often normal even in markets where competition exists, or that is, “irrespective of the degree of competition which the firm has to meet” (Andrews 1949: 58–59). When firms wish to increase market share, it will often be by means of superior quality and reputation, rather than price cuts (Downward 1999: 50).

Finally, I note how John Kenneth Galbraith in his own important work on administered prices also drew on this earlier literature, particularly Berle and Means and Kalecki (Dunn 2011: 144, n. 46).

Tuesday, May 7, 2013

The mistakes and oversights that Keynes made in the General Theory are arguably as follows:

(1) the assumption of an exogenous money supply;

(2) the marginal efficiency of capital (MEC) idea. Keynes, in developing the MEC, failed to free himself from the neoclassical marginal productivity of capital (King 2002: 209):

“[sc. Keynes] made a fatal mistake in offering a quasi-long-period definition of the inducement to invest as the ‘marginal efficiency of capital’, that is, the profit that will be realised on the increment to the stock of capital that results from current investment and, still worse, identified the profitability of capital with its social utility. This was an element in the old doctrine from which he failed to escape. He had an alternative concept of the inducement to invest as the expected future return on sums of finance to be devoted to investment. Minsky (1976) points out that he did not seem to recognise the difference between the two formulations. If he had stuck to his short-period brief, he would have used only the second.” (Robinson 1979: 179–180).

The MEC seems to suggest that there exists a rate of interest which is low enough to induce full utilization of capital goods. But this is just smuggling in the Wicksellian natural rate of interest, when Keynes had wanted to abandon the natural rate.

A number of Post Keynesians reject the MEC, because it is based on the neoclassical or marginalist theory of distribution.

(3) Keynes did not sufficiently stress the role of uncertainty and expectations in undermining the coordinating role of interest rates (King 2002: 14). In Chapter 18 of the General Theory, Keynes played down the role of uncertainty (which he had stressed in Chapter 12) and, if he had really maintained the crucial role of uncertainty (as he did later in Keynes 1937), this would have “ruled out any stable functional relationship between investment and the interest rate” (King 2002: 14). The door was thereby left open for neoclassical synthesis Keynesians to reformulate the General Theory as a general equilibrium model where the interest rate has a pivotal role (King 2002: 14).

(4) In Chapter 2 of the General Theory, Keynes used the marginal productivity of labour concept. Later he was criticised by Lorie Tarshis and Dunlop, who invoked empirical evidence on pro-cyclical wages, and in Keynes (1939) he came to reject this marginalist idea, apparently giving some endorsement of Kalecki’s theories.

Other possible problems include:

(1) Did Keynes properly understand the heterogeneous nature of capital goods? Possibly he did (see Hayes 2007), though the Cambridge capital debates were long after he died;

(2) Did Keynes understand the extent and significance of fixprice markets? One charge against Keynes is that the General Theory does not consider fixprice markets properly. By contrast, Michał Kalecki did understand fixprices, in his ideas on cost-determined pricing. Kalecki and later Post Keynesians understood that as long as excess capacity exists in fixprice market firms, then government stimulus produces direct increases in output and employment in the latter markets, not just inflation.

Apart from the fact that Keynes appears to have been bisexual, not exclusively homosexual, and apparently lived as a normal married man who was romantically and sexually attracted to his wife Lydia Lopokova after his marriage, the various other ideas dragged up by Ferguson are wrong on so many levels.

The most important issue is, quite simply, Keynes was not indifferent to the long run at all. Ferguson, Hoppe, and a long line of other idiots hostile to Keynes do not know what they are talking about.

All the controversy comes from Keynes’s assertion that “in the long run we are all dead.” This is a statement lifted from Keynes’s A Tract on Monetary Reform (1923) that is often taken out of context and misunderstood, as Matias Vernengo argues here.

When Keynes wrote A Tract on Monetary Reform, he was still a believer in the truth of the quantity theory of money, and stated that its “correspondence with fact is not open to question” (Keynes 1923: 74). Keynes even thought that

“… money as such has no utility except what is derived from its exchange-value, that is to say from the utility of the things which it can buy” (Keynes 1923: 75).

Keynes then proceeded to defend the quantity theory and the direct relation “between the quantity of cash … and the level of prices” (Keynes 1923: 78). So Keynes was not even a “Keynesian” when he wrote these words.

In his discussion of the quantity theory in A Tract on Monetary Reform, Keynes uses the following equation:

n = p(k + rk′),

wheren = quantity of money, or currency notes or other forms of cash in public circulation;p = the index number of the cost of living;k = consumption units of cash on hand;k′ = money people want to be available in banks in the form of their demand deposits or checking accounts;r = cash reserves of the banks.

In this version, Keynes thinks that as long as k, k′ and r remain unchanged, if n rises, then p will rise too (Keynes 1923: 77).

Both k and k′ appear to be roughly the equivalent of kd in the Cambridge Cash Balance equation (see Appendix below).

Shortly after this discussion comes the famous passage:

“The error often made by careless adherents of the Quantity Theory, which may partly explain why it is not universally accepted, is as follows. Every one admits that the habits of the public in the use of money and of banking facilities and the practices of the banks in respect of their reserves change from time to time as the result of obvious developments. These habits and practices are a reflection of changes in economic and social organisation. But the theory has often been expounded on the further assumption that a mere change in the quantity of the currency cannot affect k, r, and k′, — that is to say, in mathematical parlance that n is an independent variable in relation to these quantities. It would follow from this that an arbitrary doubling of n, since this in itself is assumed not to affect k, r, and k′, must have the effect of raising p to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form.

Now ‘in the long run’ this is probably true. If, after the American Civil War, the American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that n and p would now be just 10 per cent greater than they actually are and that the present values of k, r, and k′ would be entirely unaffected. But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” (Keynes 1923: 79–80).

In other words, the famous “in the long run we are all dead” statement was about the long run and short run effects as predicted by the quantity theory, not about deficit spending or Keynesian stimulus.

In essence, Keynes’s passage boils down to the instability of the demand to hold money.

Keynes concluded that the quantity of money and the cash reserves of the banks are “under the direct control (or ought to be) of the central banking authorities” (Keynes 1923: 84).

In contrast, the money that people desire to hold either as (1) cash on hand or (2) in the form of demand deposits or checking accounts changes, and is not under the control of the central bank. The latter “depends on the mood of the public and the business world” (Keynes 1923: 84).

So Keynes concludes:

“The business of stabilising the price level, not merely over long periods but so as also to avoid cyclical fluctuations, consists partly in exercising a stabilising influence over k and k′, and, in so far as this fails or is impracticable, in deliberately varying n and r so as to counterbalance the movement of k and k′.

The usual method of exercising a stabilising influence over k and k′, especially over k′, is that of bank-rate. A tendency of k′ to increase may be somewhat counteracted by lowering the bank-rate, because easy lending diminishes the advantage of keeping a margin for contingencies in cash. Cheap money also operates to counterbalance an increase of k′, because, by encouraging borrowing from the banks, it prevents r from increasing or causes r to diminish. But it is doubtful whether bank-rate by itself is always a powerful enough instrument, and, if we are to achieve stability, we must be prepared to vary n and r on occasion.

Our analysis suggests that the first duty of the central banking and currency authorities is to make sure that they have n and r thoroughly under control. For example, so long as inflationary taxation is in question n will be influenced by other than currency objects and cannot, therefore, be fully under control; moreover, at the other extreme, under a gold standard n is not always under control, because it depends on the unregulated forces which determine the demand and supply of gold throughout the world. Again, without a central banking system r will not be under proper control because it will be determined by the unco-ordinated decisions of numerous different banks.

At the present time in Great Britain r is very completely controlled, and n also, so long as we refrain from inflationary finance on the one hand and from a return to an unregulated gold standard on the other. The second duty of the authorities is therefore worth discussing, namely, the use of their control over n and r to counterbalance changes in k and k′. Even if k and k′ were entirely outside the influence of deliberate policy, which is not in fact the case, nevertheless p could be kept reasonably steady by suitable modifications of the values of n and r.

Old-fashioned advocates of sound money have laid too much emphasis on the need of keeping n and r steady, and have argued as if this policy by itself would produce the right results. So far from this being so, steadiness of n and r, when k and k′ are not steady, is bound to lead to unsteadiness of the price level. Cyclical fluctuations are characterised, not primarily by changes in n or r, but by changes in k and k′. It follows that they can only be cured if we are ready deliberately to increase and decrease n and r, when symptoms of movement are showing in the values of k and k′.” (Keynes 1923: 85–86).

So what we have here is Keynes the quasi-monetarist advocating short-term monetarist solutions to changes in the demand to hold money. To avoid destabilising price level shocks, Keynes argued that the bank rate must be changed.

The neoclassical theory held that in the long run markets would adjust and return to full employment equilibrium in response to shocks, and Keynes seems to have agreed, but – like other Marshallian neoclassicals – argued that short term pain from the destabilising forces of deflation during recessions was unnecessary and monetary interventions should be used to stabilise economies.

Appendix
Keynes’s formulation of the quantity theory is different from the Cambridge Cash Balance equation:

M = kdPY

where M = quantity of money;kd = the demand to hold money per unit of money income;P = the price levelY = the volume of all transactions that enter into the value of national income (goods and services).

M and P are causally related, if kd and Y are constant (Thirlwall 1999).

Saturday, May 4, 2013

Rochon and Rossi (2013) is a new discussion of the history of endogenous money in the latest Review of Keynesian Economics.

Economists are divided into two groups on the role of money in economic life, as follows:

(1) neoclassicals who think money is just a “neutral veil” over the real exchanges and activity in an economy. Money, in this view, is neutral in long run (monetarism), or neutral in both the short and long run (New Classical economics), and influences only nominal magnitudes (e.g., inflation), not real variables; and

(2) those heterodox economists, such as Post Keynesians, Monetary Circuit theorists, Sraffians, Old American Institutionalists, Marxists and Austrians, who think money is never neutral, either in the short and long run, and that monetary analysis captures fundamental truths about capitalist economies.

On the Post Keynesian view, it is not possible to study economics, without understanding money and its relation to output, production, investment and income (Rochon and Rossi 2013: 211).

The highest form of money with the power to finally extinguish all debts and taxes is fiat money created by the state, such as

(1) coins and notes, and

(2) base money created by central banks, which usually functions as private bank reserves.

Both these constitute high powered money, the monetary base, base money or in many countries what is called M0.

But most money in a modern capitalist economy is not fiat base money. Most money is actually credit money created by private banks and financial institutions, specifically the “bank money” of demand deposits and demand deposit-like accounts, such as checking accounts, transactions accounts and even some (so-called) savings accounts. The broad money stock mostly consists of credit money of this type.

Every time (1) a demand deposit or demand deposit-like account is opened or (2) credit is granted by a financial institution and a corresponding demand deposit account is created, new money is created. This money is destroyed as it is drawn down by the account-holder, or what we conventionally think of as “withdrawing” money, though that term is misleading, because such a bank account is not a bailment (that is, not, in legal terms, a depositum regulare).

Thus money is endogenous in the sense that it is mostly created and destroyed by the private banking system and, above all, created in response to the demand for it.

That is to say, money creation is normally credit-driven.

By contrast, mainstream neoclassical theory – apart from some New Keynesian and New Consensus macroeconomics which does recognise a limited form of endogenous money – sees money as exogenous and broad money creation as governed by the money multiplier. The latter views are wrong.

We see proof of this in the fact that bout after bout of Quantitative Easing (QE) have failed to restore full employment since 2008 (Rochon and Rossi 2013: 211).

But Post Keynesianism holds that the private banks are not constrained by their prior holdings of reserves, and that they will extend credit to all the clients that they deem to be creditworthy, although their credit standards may change over time, in that they might be lax during booms and more stringent during recessions (Rochon and Rossi 2013: 212).

Both broad money and, given that central banks have to accommodate the demand for reserves, even base money can be seen as endogenous.

But has money always been endogenous?

Post Keynesians have been divided on this question, and two views exist:

(1) The “evolutionary” view holds that money only became endogenous quite recently as the consequence of “financial innovations and/or an accommodating central bank” (Rochon and Rossi 2013: 212). Whether money was endogenous or exogenous depends on the historical period involved. This view is associated with Chick (1986).

So who is right? Rochon and Rossi set out to answer that question and conclude that the “revolutionary” Post Keynesian view is right.

Rochon and Rossi argue that a society does not need a central bank for money supply to be endogenous to some extent (Rochon and Rossi 2013: 221).

Rochon and Rossi point out that throughout history we can find many examples of monetary systems in which credit money was created in response to demand for it, and where such credit money was elastic, and acted as a medium of exchange and means of payment (Rochon and Rossi 2013: 219). This kind of money is just a social relation.

This “debt money” or “credit money” represents the manner by which debts and debt/credit relationships between a borrower and a lender create an obligation that can be monetised and transferred, so that they then function as money.

For example, elastic credit money systems existed in ancient Egypt, Greece and Rome. As the financial revolution unfolded in late medieval Italian city states, bank money that was used as a genuine medium of exchange became a fundamental part of the money supply (Rochon and Rossi 2013: 219).

Before the 17th century, however, it was not exchangeable paper banknotes or instruments that constituted this money, but accounting entries or “book-entry money” (Rochon and Rossi 2013: 219), which was revolutionised by the entry of double-entry bookkeeping in the 13th century (Rochon and Rossi 2013: 218).

Even when physical goldsmiths notes or banknotes became important, these were just a paper representation of a bank deposit or debt owed, and a way to indicate how debts had been transferred (Rochon and Rossi 2013: 222).

Rochon and Rossi conclude that

“contrary to the argument provided by Chick (1986), money did not become endogenous over time. In fact, money has always been endogenous because of the necessarily triangular relationship involving a payer, a payee and a record keeper, even in those ancient times when money’s functions were carried out using a precious metal or, more generally, a given commodity; and this with or without the existence of ‘banks’ as such. In modern times, the banking system cannot but always respond to the needs of the economy to produce and exchange real goods and services – within as well as across borders. This is so even under a gold-standard system, as Joan Robinson (1956) noticed cogently” (Rochon and Rossi 2013: 225).

I would agree that money supply, even before the age of modern fiat money (that began in the 1930s as the gold standard was effectively abolished), was to an important degree endogenous.

The part of the money supply that was endogenous was the broad money stock. This was expanded by the creation of monetised debts and then the emergence of modern banks and their creation of demand deposits.

The evidence for how even the gold standard period had a system of endogenous money can be seen in my post here: